Disadvantages of Index Funds Over Mutual Funds in India
Index funds have become increasingly popular in India due to their low cost, simplicity, and potential to deliver market returns. However, they come with certain limitations, especially when compared to actively managed mutual funds. While index funds aim to replicate the performance of a market index like the Nifty 50 or Sensex, actively managed mutual funds involve fund managers who try to outperform the market through research-based stock selection. In the Indian context, this distinction has important implications.
Limited Scope for Outperformance
One of the key disadvantages of index funds in India is their inability to outperform the market. Index funds track a benchmark and aim to mirror its returns. They do not have any strategy to beat the index. In contrast, many actively managed mutual funds in India have consistently outperformed their benchmarks over the long term, especially in less efficient segments like mid-cap and small-cap funds, where active stock-picking can create significant value.
Indian markets are still considered relatively inefficient compared to developed markets like the U.S. This inefficiency allows skilled fund managers to identify undervalued stocks and generate alpha. With index funds, this opportunity is missed entirely.
Exposure to Overvalued or Poor-Quality Stocks
Index funds in India are typically market-cap-weighted. This means that stocks with higher market capitalisation get a higher weight in the index fund portfolio. As a result, index funds may end up allocating more to overvalued or momentum-driven stocks, regardless of their fundamentals. For example, if a large-cap stock rallies due to speculation or hype, an index fund is forced to buy more of it simply because it has a larger market cap.
Actively managed funds in India have the flexibility to avoid such overvalued stocks. Fund managers can assess a company’s financials, governance, and growth prospects before investing.
Lack of Downside Protection
During a market downturn, index funds offer no protection. They continue to hold the same basket of stocks regardless of market conditions. This can result in higher volatility and deeper losses during bear phases. In contrast, active mutual fund managers can move to cash, reduce exposure to risky sectors, or rebalance their portfolio to more defensive stocks during turbulent times.
Given the relatively high volatility and sector-specific risks in Indian markets, this active risk management can be beneficial.
Limited Index Options in India
Compared to developed countries, the Indian market offers fewer quality indices with adequate diversification. Most index funds in India track large-cap indices like Nifty 50 or Sensex. This limits investor options if they want exposure to themes like value, dividend, ESG, or certain sectors.
Actively managed funds, however, offer a wide variety of schemes tailored to investor needs, including thematic funds (e.g., pharma, IT, infrastructure), hybrid funds, and value-based investing.
Tracking Errors and Higher Costs Than Expected
Although index funds are promoted as low-cost, they still carry some expenses in the Indian context. These include tracking errors (differences between fund return and index return), especially due to cash drag or illiquid stocks. Moreover, some Indian index funds still have expense ratios higher than global counterparts, reducing the cost advantage they’re supposed to offer.
How to compare index funds with mutual funds
Suppose an investor in India in 2022 invested ₹1 lakh in a Nifty 50 index fund, expecting stable and diversified growth. That year, the IT sector, which has significant weight in Nifty 50, underperformed sharply due to global economic concerns. Despite the slowdown in earnings of IT majors, the fund continued holding these stocks in high proportion, as mandated by the index.
Meanwhile, an actively managed large-cap mutual fund recognized the upcoming pressure in IT and reallocated funds into banking and capital goods sectors, which were showing strong growth and healthy balance sheets. As a result, the active fund outperformed the index fund both in returns and in managing downside risk.
Summary
Index funds in India offer an easy, low-cost way to invest, but they come with notable disadvantages compared to actively managed mutual funds. The lack of flexibility, inability to outperform, exposure to overvalued stocks, and limited index choices make them less suitable in certain market conditions. While index funds can play a role in a diversified portfolio, relying solely on them may not be ideal for Indian investors seeking long-term alpha and better risk-adjusted returns.
